Lecture 10

Bond Portfolio
Management

1
2
 Learning Objectives
1) the five basic steps involved in the investment
management process
2) the difference between active and passive strategies
3) what tracking error is and how it is computed
4) the difference between forward-looking and backward-
looking tracking error
5) the link between tracking error and active portfolio
management
6) the risk factors that affect a benchmark index
7) the importance of knowing the market consensus
before implementing an active strategy

3
Learning Objectives (continued)
8) the different types of active bond portfolio strategies:
interest-rate expectations strategies, yield curve
strategies, yield spread strategies, option-adjusted
spread-based strategies, and individual security
selection strategies
9) bullet, barbell, and ladder yield curve strategies
10) the limitations of using duration and convexity to
assess the potential performance of bond portfolio
strategies
11) why it is necessary to use the dollar duration when
implementing a yield spread strategy
12) how to assess the allocation of funds within the
corporate bond sector
13) why leveraging is used by managers and traders and
the risks and rewards associated with leveraging
14) how to leverage using the repo market 4
 Overview of the Investment
Management Process
 Regardless of the type of financial institution, the
investment management process involves the
following five steps:
i. setting investment objectives
ii. establishing investment policy
iii. selecting a portfolio strategy
iv. selecting assets
v. measuring and evaluating performance

5
 Overview of the Investment
Management Process (continued)
 Setting Investment Objectives
 The first step in the investment management process
is setting investment objectives.
• The investment objective will vary by type of
financial institution.
 Establishing Investment Policy
 The second step in investment management process is
establishing policy guidelines for meeting the
investment objectives.
• Setting policy begins with the asset allocation
decision so as to decide how the funds of the
institution should be distributed among the major
classes of investments (cash equivalents, equities,
fixed-income securities, real estate, and foreign
securities).
6
 Overview of the Investment
Management Process (continued)
 Selecting a Portfolio Strategy
 Selecting a portfolio strategy that is consistent with
the objectives and policy guidelines of the client or
institution is the third step in the investment
management process.
 Portfolio strategies can be classified as either active
strategies or passive strategies.
 Essential to all active strategies is specification of
expectations about the factors that influence the
performance of an asset class. Passive strategies
involve minimal expectational input.
7
 Overview of the Investment
Management Process (continued)
 Selecting a Portfolio Strategy
 Strategies between the active and passive extremes
have sprung up that have elements of both extreme
strategies.
 For example, the core of a portfolio may be indexed,
with the balance managed actively.
 Or a portfolio may be primarily indexed but employ
low-risk strategies to enhance the indexed portfolio’s
return.
 This strategy is commonly referred to as enhanced
indexing or indexing plus.
8
 Overview of the Investment
Management Process (continued)
 Selecting a Portfolio Strategy
 In the bond area, several strategies classified as structured
portfolio strategies have commonly been used.
 A structured portfolio strategy calls for design of a portfolio
to achieve the performance of a predetermined benchmark.
 Such strategies are frequently followed when funding
liabilities.
 When the predetermined benchmark is the generation of
sufficient funds to satisfy a single liability, regardless of the
course of future interest rates, a strategy known as
immunization is often used.
 When the predetermined benchmark requires funding
multiple future liabilities regardless of how interest rates
change, strategies such as immunization, cash flow matching
(or dedication), or horizon matching can be employed.
9
 Overview of the Investment
Management Process (continued)
 Selecting a Portfolio Strategy
 Given the choice among active, structured, or
passive management, the selection depends on
i. the client or money manager’s view of the pricing
efficiency of the market
ii. the nature of the liabilities to be satisfied
 Pricing efficiency is taken to describe a market
where prices at all times fully reflect all available
information that is relevant to the valuation of
securities.
 When a market is price efficient, active strategies
will not consistently produce superior returns after
adjusting for risk and transactions costs.

10
 Overview of the Investment
Management Process (continued)
 Selecting Assets
 After a portfolio strategy is specified, the fourth step
in the investment management process is to select the
specific assets to be included in the portfolio, which
requires an evaluation of individual securities.
• It is in this phase that the investment manager
attempts to construct an efficient portfolio.
• An efficient portfolio is one that provides the
greatest expected return for a given level of risk, or,
equivalently, the lowest risk for a given expected
return.

11
 Overview of the Investment
Management Process (continued)
 Measuring and Evaluating Performance
 The measurement and evaluation of investment
performance is the fifth and last step in the
investment management process.
• This step involves measuring the performance of the
portfolio, then evaluating that performance relative
to some benchmark.
• The benchmark selected for evaluating performance
is called a benchmark or normal portfolio.
• The benchmark portfolio may be a popular index
such as the S&P 500 for equity portfolios or one of
the bond indexes.

12
 Tracking Error and Bond
Portfolio Strategies
 Before discussing bond portfolio strategies, it is
essential to understand an important analytical
concept.
 When a portfolio manager’s benchmark is a bond
market index, risk is not measured in terms of the
standard deviation of the portfolio’s return.
 Instead, risk is measured by the standard deviation of
the return of the portfolio relative to the return of the
benchmark index.
 This risk measure is called tracking error.
 Tracking error is also called active risk.
13
 Tracking Error and Bond
Portfolio Strategies (continued)
 Calculation of Tracking Error
 Tracking error is computed as follows:
Step 1: Compute the total return for a portfolio for each
period.
Step 2: Obtain the total return for the benchmark index for
each period.
Step 3: Obtain the difference between the values found in
Step 1 and Step 2. The difference is referred to as the
active return.
Step 4: Compute the standard deviation of the active
returns. The resulting value is the tracking error.
 The tracking error measurement is in terms of the
observation period.  If monthly returns are used, the
tracking error is a monthly tracking error.  If weekly
returns are used, the tracking error is a weekly tracking
error. 14
 Tracking Error and Bond
Portfolio Strategies (continued)
 Exhibit 1 shows the calculation of the tracking error for two hypothetical
portfolios assuming that the benchmark is the Lehman U.S. Aggregate
Index.
 Portfolio A’s monthly tracking error is 9.33 basis points where the
monthly returns of the portfolio closely track the return of the benchmark
index—that is, the active returns are small.
 In contrast, for Portfolio B, the active returns are large, and thus, the
monthly tracking error is large—79.13 basis points.
 The tracking error is unique to the benchmark used.
 Exhibit 2 shows the tracking error for the portfolios using the former
Lehman Global Aggregate Index.
 The monthly tracking error for Portfolio A is 76.03 basis points for the
Lehman Global Index compared to 9.33 basis points when the
benchmark is the Lehman U.S. Aggregate Index; for Portfolio B, it is
11.92 basis points for the Lehman Global Index versus 79.13 basis points
15
for the Lehman U.S. Aggregate Index.
 Exhibit 1 Calculation of Tracking Error for Two Hypothetical Portfolios:
Benchmark Is the Lehman U.S. Aggregate Index (Portfolio A)
Observation period = January 2007–December 2007; Benchmark index = Lehman U.S. Aggregate Index
Portfolio A
Portfolio Benchmark Index Active
Month in 2007
Return (%) Return (%) Return (%)
January -0.02 -0.04 0.02
February 1.58 1.54 0.04
March -0.04 0.00 -0.04
April 0.61 0.54 0.07
May -0.71 -0.76 0.05
June -0.27 -0.30 0.03
July 0.91 0.83 0.08
August 1.26 1.23 0.03
September 0.69 0.76 -0.07
October 0.95 0.90 0.05
November 1.08 1.04 0.04
December 0.02 0.28 -0.26
Sum 0.040
Mean 0.0033
Variance 0.0087
Standard Deviation = Tracking error 0.0933

Tracking error (in basis points) 9.33

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 Exhibit 1 Calculation of Tracking Error for Two Hypothetical Portfolios:
Benchmark Is the Lehman U.S. Aggregate Index (Portfolio B)
Observation period = January 2007–December 2007; Benchmark index = Lehman U.S. Aggregate Index
Portfolio B
Portfolio Benchmark Index Active
Month in 2007
Return (%) Return (%) Return (%)
January -1.05 -0.04 -1.01
February 2.13 1.54 0.59
March 0.37 0.00 0.37
April 1.01 0.54 0.47
May -1.44 -0.76 -0.68
June -0.57 -0.30 -0.27
July 1.95 0.83 1.12
August 1.26 1.23 0.03
September 2.17 0.76 1.41
October 1.80 0.90 0.90
November 2.13 1.04 1.09
December -0.32 0.28 -0.60
Sum 3.42
Mean 0.2850
Variance 0.6262
Standard Deviation = Tracking error 0.7913

Tracking error (in basis points) 79.13

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 Calculating Variance and Standard
Deviation (for Exhibit 1/Portfolio A)
xi (xi - xbar)^2
0.02
0.0003
0.04
0.0013
-0.04
0.0019
0.07
0.0044
0.05
0.0022
0.03 0.0007
0.08 0.0059
0.03 0.0007
-0.07 0.0054
0.05 0.0022
0.04 0.0013
-0.26 0.0693
mean/xbar 0.0033
St. Deviation 0.09327 18
 Exhibit 2 Calculation of Tracking Error for Two Hypothetical Portfolios:
Benchmark Is the Lehman Global Aggregate Index (Portfolio A)
Observation period = January 2007–December 2007; Benchmark index = Lehman Global Aggregate Index
Portfolio A
Portfolio Benchmark Index Active
Month in 2007
Return (%) Return (%) Return (%)
January -0.02 -0.98 0.96
February 1.58 2.06 -0.48
March -0.04 0.24 -0.28
April 0.61 1.13 -0.52
May -0.71 -1.56 0.85
June -0.27 -0.44 0.17
July 0.91 2.03 -1.12
August 1.26 1.23 0.03
September 0.69 2.24 -1.55
October 0.95 1.63 -0.68
November 1.08 1.91 -0.83
December 0.02 -0.31 0.33
Sum -3.12
Mean -0.26
Variance 0.5781
Standard Deviation = Tracking error 0.7603

Tracking error (in basis points) 76.03

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 Exhibit 2 Calculation of Tracking Error for Two Hypothetical Portfolios:
Benchmark Is the Lehman Global Aggregate Index (Portfolio B)
Observation period = January 2007–December 2007; Benchmark index = Lehman Global Aggregate Index

Portfolio B
Portfolio Benchmark Index Active
Month in 2007
Return (%) Return (%) Return (%)
January -1.05 -0.98 -0.07
February 2.13 2.06 0.07
March 0.37 0.24 0.13
April 1.01 1.13 -0.12
May -1.44 -1.56 0.12
June -0.57 -0.44 -0.13
July 1.95 2.03 -0.08
August 1.26 1.23 0.03
September 2.17 2.24 -0.07
October 1.80 1.63 0.17
November 2.13 1.91 0.22
December -0.32 -0.31 -0.01
Sum 0.26
Mean 0.0217
Variance 0.0142
Standard Deviation = Tracking error 0.1192
Tracking error (in basis points) 11.92

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Tracking Error and Bond Portfolio
Strategies (continued)
 Two Faces of Tracking Error
 Calculations computed for a portfolio based on a
portfolio’s actual active returns reflect the portfolio
manager’s decisions during the observation period.
• We call tracking error calculated from observed active
returns for a portfolio backward-looking tracking error.
• It is also called the ex-post tracking error and the actual
tracking error.
 The portfolio manager needs a forward-looking estimate
of tracking error to reflect the portfolio risk going
forward.
• The way this is done in practice is by using the services
of a commercial vendor or dealer firm that has modeled
the factors that affect the tracking error associated with
the bond market index that is the portfolio manager’s
benchmark. 21
• These models are called multi-factor risk models.
Tracking Error and Bond Portfolio
Strategies (continued)
 Two Faces of Tracking Error
 Given a manager’s current portfolio holdings, the
portfolio’s current exposure to the various risk
factors can be calculated and compared to the
benchmark’s exposures to the factors.
 Using the differential factor exposures and the risks
of the factors, a forward-looking tracking error for
the portfolio can be computed.
 This tracking error is also referred to as predicted
tracking error and ex-ante tracking error.

22
 Tracking Error and Bond Portfolio
Strategies (continued)
 Tracking Error and Active Versus passive strategies
 We can think of active versus passive bond portfolio strategies
in terms of forward-looking tracking error.
 In constructing a portfolio, a manager can estimate its
forward-looking tracking error.
 When a portfolio is constructed to have a forward-looking
tracking error of zero, the manager has effectively designed
the portfolio to replicate the performance of the benchmark.
 If the forward-looking tracking error is maintained for the
entire investment period, the active return should be close to
zero.
 Such a strategy—one with a forward-looking tracking error of
zero or very small—indicates that the manager is pursing a23
passive strategy relative to the benchmark index.
Tracking Error and Bond Portfolio
Strategies (continued)
 Risk Factors and Portfolio Management
Strategies
 Forward-looking tracking error indicates the degree of
active portfolio management being pursued by a
manager.
• Therefore, it is necessary to understand what factors
(referred to as risk factors) affect the performance of a
manager’s benchmark index.
• A summary of the risk factors is provided in Exhibit 3
 Risk factors can be classified into two types:
i. A systematic risk factor is a force that affect all securities
in a certain category in the benchmark index.
ii. A nonsystematic risk factor refers to risk that is not
attributable to systematic risk factors.

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 Exhibit 3 Summary of Risk Factors for a Benchmark

Systematic Non-Systematic
Risk Factors Risk Factors

Term Structure Non-Term Structure Issuer Issue

Risk Factors Risk Factors Specific Specific

sector risk
quality risk
optionality risk
coupon risk
MBS sector risk
MBS volatility risk
MBS prepayment risk
25
 Tracking Error and Bond
Portfolio Strategies (continued)
 Risk Factors and Portfolio Management Strategies
 Systematic risk factors, in turn, are divided into two categories: term
structure risk factors and non-term structure risk factors.
• Term structure risk factors are risks associated with changes in the
shape of the term structure (level and shape changes).
• Non-term structure risk factors include sector risk, quality risk,
optionality risk, coupon risk, MBS sector risk, MBS volatility risk,
and MBS prepayment risk.
• Sector risk is the risk associated with exposure to the sectors of the
benchmark index.
• Quality risk is the risk associated with exposure to the credit rating of
the securities in the benchmark index.
• Optionality risk is the risk associated with an adverse impact on the
embedded options of the securities in the benchmark index.
• Coupon risk is the exposure of the securities in the benchmark index 26

to different coupon rates.

 Tracking Error and Bond
Portfolio Strategies (continued)
 Risk Factors and Portfolio Management Strategies
 The last three non-term risks (MBS sector risk, MBS
volatility risk, and MBS prepayment risk) are associated
with the investing in residential mortgage pass-through
securities.
• MBS sector risk is the exposure to the sectors of the MBS
market included in the benchmark.
• MBS volatility risk is the exposure of a benchmark index to
changes in expected interest-rate volatility.
• MBS prepayment risk is the exposure of a benchmark index
to changes in prepayments.
 Nonsystematic factor risks are classified as nonsystematic
risks associated with a particular issuer, issuer-specific risk,
and those associated with a particular issue, issue-specific
risk.
27
 Tracking Error and Bond
Portfolio Strategies (continued)
 Determinants of Tracking Error
 Once we know the risk factors associated with a
benchmark index, forward-looking tracking error can be
estimated for a portfolio.
 The tracking error occurs because the portfolio
constructed deviates from the exposures for the
benchmark index.
 A manager provided with information about
(forwarding-looking) tracking error for the current
portfolio can quickly assess if
i. the risk exposure for the portfolio is one that is
acceptable
ii. if the particular exposures are being sought

28
 Active Portfolio Strategies
 Manager Expectations Versus the Market
Consensus
 A money manager who pursues an active strategy will
position a portfolio to capitalize on expectations about
future interest rates, but the potential outcome (as
measured by total return) must be assessed before an
active strategy is implemented.
 The primary reason for this is that the market
(collectively) has certain expectations for future interest
rates and these expectations are embodied into the
market price of bonds.
 Though some managers might refer to an “optimal
strategy” that should be pursued given certain
expectations, that is insufficient information in making
an investment decision.
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 Active Portfolio Strategies (continued)
 Interest-Rate Expectations Strategies
 A money manager who believes that he or she can
accurately forecast the future level of interest rates will
alter the portfolio’s sensitivity to interest-rate changes.
 A portfolio’s duration may be altered by swapping (or
exchanging) bonds in the portfolio for new bonds that
will achieve the target portfolio duration.
• Such swaps are commonly referred to as rate
anticipation swaps.
 Although a manager may not pursue an active strategy
based strictly on future interest-rate movements, there
can be a tendency to make an interest-rate bet to cover
inferior performance relative to a benchmark index.

30
 Active Portfolio Strategies (continued)
 Yield Curve Strategies
 The yield curve for U.S. Treasury securities shows the
relationship between their maturities and yields.
 The shape of this yield curve changes over time.
 Yield curve strategies involve positioning a portfolio to
capitalize on expected changes in the shape of the
Treasury yield curve.
 A shift in the yield curve refers to the relative change in
the yield for each Treasury maturity.
 A parallel shift in the yield curve is a shift in which the
change in the yield on all maturities is the same.
 A nonparallel shift in the yield curve indicates that the
yield for maturities does not change by the same
number of basis points.

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 Active Portfolio Strategies (continued)
 Yield Curve Strategies
 Historically, two types of nonparallel yield curve shifts
have been observed: a twist in the slope of the yield
curve and a change in the humpedness of the yield
curve.
 A flattening of the yield curve indicates that the yield
spread between the yield on a long-term and a short-
term Treasury has decreased; a steepening of the yield
curve indicates that the yield spread between a long-
term and a short-term Treasury has increased.
 The other type of nonparallel shift, a change in the
humpedness of the yield curve, is referred to as a
butterfly shift.

32
Active Portfolio Strategies (continued)
 Yield Curve Strategies
 Frank Jones analyzed the types of yield curve shifts
that occurred between 1979 and 1990.
 He found that the three types of yield curve shifts are
not independent, with the two most common types of
yield curve shifts being
i. a downward shift in the yield curve combined with a
steepening of the yield curve
ii. an upward shift in the yield curve combined with a
flattening of the yield curve.
 These two types of shifts in the yield curve are
depicted in Exhibit 4

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Exhibit 4 Combinations of Yield Curve Shifts
Upward Shift/Flattening/Positive Butterfly
Yield

Positive Butterfly

Flattening
Parallel

Maturity
34
Exhibit 4 Combinations of Yield Curve Shifts
Downward Shift/Steepening/Negative Butterfly
Yield

Parallel
Steepening
Negative Butterfly

Maturity
35
Active Portfolio Strategies (continued)
 Yield Curve Strategies
 In portfolio strategies that seek to capitalize on expectations
based on short-term movements in yields, the dominant
source of return is the impact on the price of the securities in
the portfolio.
• This means that the maturity of the securities in the portfolio
will have an important impact on the portfolio’s return.
• The key point is that for short-term investment horizons, the
spacing of the maturity of bonds in the portfolio will have a
significant impact on the total return.
 In a bullet strategy, the portfolio is constructed so that the
maturities of the securities in the portfolio are highly
concentrated at one point on the yield curve.
 In a barbell strategy, the maturities of the securities in the
portfolio are concentrated at two extreme maturities.
 In a ladder strategy the portfolio is constructed to have
approximately equal amounts of each maturity.

36
Active Portfolio Strategies (continued)
 Duration and Yield Curve Shifts
 Duration is a measure of the sensitivity of the price of a
bond or the value of a bond portfolio to changes in market
yields.
 A bond with a duration of 6 means that if market yields
change by 100 basis points, the bond’s price will change by
approximately 6%.
 However, if a three-bond portfolio has a duration of 6, the
statement that the portfolio’s value will change by 6% for a
100-basis-point change in yields actually should be stated as
follows:
The portfolio’s value will change by 6% if the yield on five-, 10-,
and 20-year bonds all change by 100 basis points. That is, it
is assumed that there is a parallel yield curve shift.
37
Active Portfolio Strategies (continued)
 Analyzing Expected Yield Curve Strategies
 The proper way to analyze any portfolio strategy is to
look at its potential total return.
 If a manager wants to assess the outcome of a portfolio for
any assumed shift in the Treasury yield curve, this should
be done by calculating the potential total return if that
shift actually occurs.
 This can be illustrated by looking at the performance of
two hypothetical portfolios of Treasury securities
assuming different shifts in the Treasury yield curve.
• The three hypothetical Treasury securities shown in
Exhibit 5 are considered for inclusion in our two
portfolios.
• For our illustration, the Treasury yield curve consists of
these three Treasury securities: a short-term security (A,
the five-year security), an intermediate-term security (C,
the 10-year security), and a long-term security (B, the 20-
year security). 38
Exhibit 5 Three Hypothetical Treasury
Securities
Yield to
Coupon Maturity Price Plus Dollar Dollar
Bond Maturity
(%) (years) Accrued Duration Convexity
(%)

A 8.50 5 100 8.50 4.005 19.8164

B 9.50 20 100 9.50 8.882 124.1702

C 9.25 10 100 9.25 6.434 55.4506

39
Active Portfolio Strategies (continued)
 Analyzing Expected Yield Curve Strategies
 Duration is just a first approximation of the change in
price resulting from a change in interest rates.
Convexity provides a second approximation.
 Dollar convexity has a meaning similar to convexity, in
that it provides a second approximation to the dollar
price change.
 For two portfolios with the same dollar duration, the
greater the convexity, the better the performance of a
bond or a portfolio when yields change.
 What is necessary to understand is that the larger the
dollar convexity, the greater the dollar price change due
to a portfolio’s convexity.

40
 Active Portfolio Strategies (continued)
 Analyzing Expected Yield Curve Strategies
 Now suppose that a portfolio manager with a six-month
investment horizon has a choice of investing in the
bullet portfolio (100% bond C) or the barbell portfolio
(50.2% bond A and 49.8% bond B).
 Which one should he choose? The manager knows that
(1) the two portfolios have the same dollar duration, (2)
the yield for the bullet portfolio is greater than that of
the barbell portfolio, and (3) the dollar convexity of the
barbell portfolio is greater than that of the bullet
portfolio.
 Actually, this information is not adequate in making the
decision. What is necessary is to assess the potential
total return when the yield curve shifts.
41
 Active Portfolio Strategies (continued)
 Analyzing Expected Yield Curve Strategies
 Exhibit 6 provides an analysis of the six-month total
return of the two portfolios when the yield curve shifts.
 The numbers reported in the exhibit are the difference
in the total return for the two portfolios.
 Specifically, the following is shown:
 difference in dollar return = bullet portfolio’s total
return – barbell portfolio’s total return
 Thus, a positive value means that the bullet portfolio
outperformed the barbell portfolio, and a negative sign
means that the barbell portfolio outperformed the bullet
portfolio.

42
Exhibit 6 Relative Performance of Bullet Portfolio and
Barbell Portfolio over a Six-Month Investment Horizon
Nonparallel Nonparallel
Yield Parallel
Shift (%) Shift (%)
Change Shift
(flattening) (steepening)
-5.000 -7.19 -10.69 -3.89
-4.750 -6.28 -9.61 -3.12
-4.500 -5.44 -8.62 -2.44
-4.250 -4.68 -7.71 -1.82
-4.000 -4.00 -6.88 -1.27
… … … …
-1.000 0.06 -1.54 1.57
… … … …
0.750 0.16 -0.97 1.21
… … … …
4.250 -1.75 -2.27 -1.27
4.500 -1.93 -2.43 -1.48
4.750 -2.12 -2.58 -1.70
5.000 -2.31 -2.75 -1.92 43
Active Portfolio Strategies (continued)
 Analyzing Expected Yield Curve Strategies
 Let’s focus on the second column of Exhibit 6, which is labeled
“parallel shift.”
 This is the relative total return of the two portfolios over the six-month
investment horizon assuming that the yield curve shifts in a parallel
fashion.
 In this case parallel movement of the yield curve means that the yields
for the short-term bond (A), the intermediate-term bond (C), and the
long-term bond (B) change by the same number of basis points, shown
in the “yield change” column of the table.
 Which portfolio is the better investment alternative if the yield curve
shifts in a parallel fashion and the investment horizon is six months?
The answer depends on the amount by which yields change.
 Notice that when yields change by less than 100 basis points, the bullet
portfolio outperforms the barbell portfolio. The reverse is true if yields
change by more than 100 basis points. 44
 Active Portfolio Strategies (continued)
 Analyzing Expected Yield Curve Strategies
 This illustration makes two key points.
i. First, even if the yield curve shifts in a parallel fashion,
two portfolios with the same dollar duration will not give
the same performance. The reason is that the two
portfolios do not have the same dollar convexity.
ii. The second point is that although with all other things
equal it is better to have more convexity than less, the
market charges for convexity in the form of a higher price
or a lower yield. But the benefit of the greater convexity
depends on how much yields change.
 As can be seen from the second column of Exhibit 6, if
market yields change by less than 100 basis points (up or
down), the bullet portfolio, which has less convexity, will
provide a better total return.

45
 Active Portfolio Strategies (continued)
 Approximating the Exposure of a Portfolio’s Yield
Curve Risk
 A portfolio and a benchmark have key rate durations.
 The extent to which the profile of the key rate durations of a
portfolio differs from that of its benchmark helps identify the
difference in yield curve risk exposure.

46
 Active Portfolio Strategies (continued)
 Yield Spread Strategies
 Yield spread strategies involve positioning a portfolio to
capitalize on expected changes in yield spreads between
sectors of the bond market.
 Swapping (or exchanging) one bond for another when the
manager believes that the prevailing yield spread between
the two bonds in the market is out of line with their
historical yield spread, and that the yield spread will realign
by the end of the investment horizon, are called intermarket
spread swaps.
 Credit or quality spreads change because of expected
changes in economic prospects. Credit spreads between
Treasury and non-Treasury issues widen in a declining or
contracting economy and narrow during economic
expansion.
 Spreads attributable to differences in callable and
noncallable bonds and differences in coupons of callable
bonds will change as a result of expected changes in (1) the
direction of the change in interest rates, and (2) interest-rate 47
volatility.
 Active Portfolio Strategies (continued)
 Individual Security Selection Strategies
 There are several active strategies that money managers
pursue to identify mispriced securities
 The most common strategy identifies an issue as
undervalued because either
i. its yield is higher than that of comparably rated issues, or
ii. its yield is expected to decline (and price therefore rise)
because credit analysis indicates that its rating will
improve.
 A swap in which a money manager exchanges one bond
for another bond that is similar in terms of coupon,
maturity, and credit quality, but offers a higher yield, is
called a substitution swap.

48
 Active Portfolio Strategies (continued)
 Strategies for Asset Allocation within Bond Sectors
 The ability to outperform a benchmark index will depend
on how the manager allocates funds within a bond sector
relative to the composition of the benchmark index.
 Exhibit 7 shows a one-year rating transition matrix (table)
based on a Moody’s study for the period 1970–1993.
 Exhibit 8 shows the expected incremental return estimates
for a portfolio consisting of only three-year Aa-rated
bonds.

49
 Exhibit 7 One-Year Rating
Transition Probabilities (%)
Aaa Aa A Baa Ba Bb C or D Total

Aaa 91.90 7.38 0.72 0.00 0.00 0.00 0.00 100.00

Aa 1.13 91.26 7.09 0.31 0.21 0.00 0.00 100.00

A 0.10 2.56 91.20 5.33 0.61 0.20 0.00 100.00

Baa 0.00 0.21 5.36 87.94 5.46 0.82 0.21 100.00

Source: From Leland E. Crabbe, “A Framework for Corporate Bond Strategy,”
Journal of Fixed Income, June 1995, p. 16. Reprinted by permission of
Institutional Investor.

50
23-50
Exhibit 8 Expected Incremental Return Estimates
for Three-Year Aa-Rated Bonds over a One-Year
Horizon
(a) (b) (a x b)
Initial Horizon Horizon Return over Transition Contribution to
Spread Rating Spread Treasuries Probability Incremental
(bp) X (%) = Return (bp)
30 Aaa 25 38 1.13 0.43
30 Aa 30 30 91.26 27.38
30 A 35 21 7.09 1.49
30 Baa 60 –24 0.31 –0.07
30 Ba 130 –147 0.21 –0.31
Portfolio Incremental Return over Treasuries = 28.91
Source: From Leland E. Crabbe, “A Framework for Corporate Bond
Strategy,” Journal of Fixed Income, June 1995, p. 17. Reprinted by
permission of Institutional Investor.

51
 The Use of Leverage
 If permitted by investment guidelines a manager may
use leverage in an attempt to enhance portfolio
returns.
 A portfolio manager can create leverage by borrowing
funds in order to acquire a position in the market that
is greater than if only cash were invested.
 The funds available to invest without borrowing are
referred to as the “equity.”
 A portfolio that does not contain any leverage is
called an unlevered portfolio.
 A levered portfolio is a portfolio in which a manager
has created leverage.
52
 The Use of Leverage
 Motivation for Leverage
(continued)
 The basic principle in using leverage is that a manager wants to
earn a return on the borrowed funds that is greater than the cost of
the borrowed funds.
 The return from borrowing funds is produced from a higher income
and/or greater price appreciation relative to a scenario in which no
funds are borrowed.
 The return from investing the funds comes from two sources.
i. interest income
ii. change in the value of the security (or securities) at the end of the
borrowing period
 There are some managers who use leverage in the hopes of
benefiting primarily from price changes.
 Small price changes will be magnified by using leveraging.
• For example, if a manager expects interest rates to fall, the manager
can borrow funds to increase price exposure to the market. 53
• Effectively, the manager is increasing the duration of the portfolio.
The Use of Leverage (continued)
 Motivation for Leverage
 The risk associated with borrowing funds is that the
security (or securities) in which the borrowed funds are
invested may earn less than the cost of the borrowed
funds due to failure to generate interest income plus
capital appreciation as expected when the funds were
borrowed.
 Leveraging is a necessity for depository institutions
(such as banks and savings and loan associations)
because the spread over the cost of borrowed funds is
typically small.
 The magnitude of the borrowing (i.e., the degree of
leverage) is what produces an acceptable return for the
institution.
54
 The Use of Leverage (continued)
 Duration of a Leveraged Portfolio
 In general, the procedure for calculating the duration of
a portfolio that uses leverage is as follows:
Step 1: Calculate the duration of the levered portfolio.
Step 2: Determine the dollar duration of the portfolio of
the levered portfolio for a change in interest rates.
Step 3: Compute the ratio of the dollar duration of the
levered portfolio to the value of the initial unlevered
portfolio (i.e., initial equity).
Step 4: The duration of the unlevered portfolio is then
found as follows:
100
ratio computed in Step 3 x x100
rate change used in Step 2 in bps
55
The Use of Leverage (continued)
 Duration of a Leveraged Portfolio (example)
 The initial value of the unlevered portfolio is €200
million and the levered portfolio is €600 million:
Step 1: The duration of the levered portfolio is 4
Step 2: 25 basis-point change in interest rates is used to
compute the dollar duration. If duration is 4 then 25bps
equals 1% change (4*0.25 = 1%) of €600 million , i.e.
€6 million
Step 3: dollar duration of €6 million/ €200 million
unlevered portfolio = 0.03
Step 4: The duration of the unlevered portfolio is:
100
0.03 x x100  12
25 56
 The Use of Leverage (continued)
 How to Create Leverage Via the Repo Market
 A manager can create leverage in one of two ways. One way is
through the use of derivative instruments. The second way is to
borrow funds via a collateralized loan arrangement.
 A repurchase agreement is the sale of a security with a commitment
by the seller to buy the same security back from the purchaser at a
specified price at a designated future date. The price at which the
seller must subsequently repurchase the security for is called the
repurchase price, and the date that the security must be repurchased
is called the repurchase date.
 There is a good deal of Wall Street jargon describing repo
transactions. To understand it, remember that one party is lending
money and accepting a security as collateral for the loan; the other
party is borrowing money and providing collateral..
 Despite the fact that there may be high-quality collateral underlying a
repo transaction, both parties to the transaction are exposed to credit
57
risk.
 The Use of Leverage (continued)
 How to Create Leverage Via the Repo Market
 Repos should be carefully structured to reduce credit risk exposure.
The amount lent should be less than the market value of the security
used as collateral, thereby providing the lender with some cushion
should the market value of the security decline. The amount by
which the market value of the security used as collateral exceeds the
value of the loan is called repo margin or simply margin.
 There is not one repo rate. The rate varies from transaction to
transaction depending on a variety of factors: quality of collateral,
term of the repo, delivery requirement, availability of collateral, and
the prevailing federal funds rate.
 The more difficult it is to obtain the collateral, the lower the repo
rate. To understand why this is so, remember that the borrower (or
equivalently the seller of the collateral) has a security that lenders of
cash want, for whatever reason. Such collateral is referred to as hot
or special collateral. Collateral that does not have this characteristic
58
is referred to as general collateral.